China
A Fiscal Check-Up
September 03, 2009

By Qing Wang | Hong Kong & Steven Zhang | Shanghai

Due for a Fiscal Check-Up

As a strong recovery is underway, some investors start to shift their attention to longer-term risks. China's fiscal situation emerges to become a key focus, given that the economic recovery has been largely driven by either direct public spending out of the state budget or indirect quasi-fiscal operations financed by bank credit.

Specifically, the Chinese government has committed Rmb1.18 billion out of its own budget to finance the Rmb4 trillion stimulus package. We forecast that the fiscal deficits in 2009-10 could widen sharply to 4-5% of GDP per year from a roughly balanced position in previous years. At the same time, judging by the very rapid expansion of bank loans since this year, the actual amount of spending carried out under the stimulus plan will likely well exceed the original target. The financing of these projects is primarily in the form of bank lending, because banks are more than willing to bankroll these (primarily infrastructure) projects with the understanding that the attendant debt is guaranteed by the local or central governments, explicitly or implicitly. A concrete example in this regard is that a number of local governments have set up special purpose vehicles (SPVs) like ‘municipal investment & construction companies' to raise funds - either through bond issuance or direct borrowing from the banks - to finance these investment projects. And these SPVs are de facto SOEs.

Some investors wonder what if these investment projects were to fail commercially. In such cases, the underlying assets would turn into non-performing assets, and the loans involved would risk becoming non-performing loans (NPLs) unless the government guarantees were to be exercised. Then the next big question is whether Chinese governments, central or local, would have a sufficiently strong fiscal position to honor their commitments.

The Officially Recognized Debt Level Is Very Low...

While there are several gauges of the strength of a government's fiscal position, the initial level of government debt is the most important one, in our opinion. Many market participants tend to pay close attention to the magnitude of fiscal deficits and think that the larger the fiscal deficit is, the weaker the fiscal position. This notion is valid only when the initial debt level is given. In practice, a low-debt-level government can afford to run large deficits for multiple years and still be considered as fiscally sound, while a high-debt-level country may maintain a balanced budget or even surplus but still be considered as fiscally unsustainable.

China's government debt stood at about 18% of GDP as of 2008 or Rmb5.3 trillion. According to the Maastricht Treaty, EU member countries are required to observe a ceiling of 60% of GDP for government debt. While there is no such hard threshold for emerging market economies, 45% of GDP seems to be the broad consensus level of debt beyond which fiscal sustainability will become an issue. This is because emerging market economies tend to have underdeveloped financial and capital markets and weak tax collection and balance of payments positions, which limit the ability of governments to maintain high debt levels without jeopardizing fiscal sustainability. Obviously, the government debt level in China is very low compared to many economies in the rest of the world, well below either threshold discussed above.

...but Contingent Fiscal Liabilities Should Be Factored in

A comprehensive assessment of a government's fiscal soundness entails taking account of contingent fiscal liabilities. There are mainly three types of contingent fiscal liabilities in China: a) non-performing loans incurred by large state-owned banks before they were restructured and recapitalized; b) the transition costs of pension reform; and c) debts incurred by local governments. According to IMF estimates, the loss stemming from NPL disposal is about Rmb3.6 trillion and the transition costs of pension reform are about Rmb1.6 trillion (IMF Country Report No. 06/394, October 2006).  While the local governments in China are not allowed to run fiscal deficits and thus incur debt, various forms of liabilities have actually been taken on by local governments in practice. A study conducted by a think tank officially affiliated with Ministry of Finance estimates that hidden local government debt, formal and contingent, amounted to as much as Rmb4 trillion as of 2008.

When contingent fiscal liabilities are factored in, the total government debt in China would reach as high as Rmb14.5 trillion, or about 48% of GDP in 2008. This is more than double the officially recognized level and exceeds the threshold of 45% for emerging market economies. Shouldn't we then be concerned about China's fiscal sustainability?

Don't Lose Sight of the Asset Side of the Balance Sheet

The seemingly high government debt - after contingent liabilities are factored in - substantially overstates the true threat to fiscal sustainability in China, in our view. This is because the asset side of the balance sheet of Chinese governments is remarkably strong. This distinguishes Chinese governments from many governments in the rest of world, who do not own many assets and whose ability to incur and service debt only hinges on one key factor: their capacity to collect tax revenue on a flow basis.

First, Chinese governments own sizeable liquid assets: cash. The outstanding central government treasury deposits in the banking system stood at Rmb1.8 trillion at end-2008, or 6% of GDP, and this number has been increasing rapidly in the last five years. Moreover, the deposits owned by other government and semi-government agencies in the banking system stood at Rmb2.2 trillion, over 7% of GDP at end-2008, and, similarly, this number has been increasing steadily in the last five years.

Second, according to official statistics, Chinese central and local governments combined own Rmb14.5 trillion worth of equity (instead of assets) in terms of book value in SOEs as of 2007, or equivalent to 48% of 2008 GDP. This is roughly equal to the total amount of government debt (including contingent liabilities).

But to what extent can government stakes in SOEs be counted on as valuable assets to back up the liabilities? Aren't SOEs typically as poorly run and loss-making in China as in many other countries? The answer is ‘not really'. Three decades of economic reform have fundamentally transformed the SOE sector in China, and the SOEs in China today couldn't be more different from the stereotype of SOEs under a planned economy. For instance, during 2003-07, Chinese industrial enterprises of above-designated size made total profits of Rmb8 trillion, of which 45% was contributed by SOEs. Another case in point is that the total market value of the state equity holdings in the large public listed companies in three sectors - banking (i.e., CCB, BOC, ICBC), oil (i.e., PetroChina, Sinopec, CNOOC), and telecom (China Mobile, China Unicom) - is worth about Rmb5.5 trillion, equivalent to 18% of GDP in 2008.

Third, don't forget land. Non-agricultural land is legally owned by the state in China. While agricultural land is in theory collectively owned by the farmers, it is effectively under the control of the government as well, because the government can take over land from farmers at substantially lower cost than the market value would suggest. We do not attempt to estimate the market value of the land controlled by the government, as this is a daunting task. But land that is directly or indirectly owned by the state are the largest and most valuable assets under the control of the governments, in our view. Just to give a rough idea: the official statistics show that the cumulative revenue from land sales accrued to the state budget during 2004-08 amounted to Rmb4.1 trillion, or equivalent to roughly 14% of GDP in 2008. And it is widely believed that the official statistics tend to understate the actual land sales revenue.

A Stress Test for Fiscal Soundness

While the anti-crisis stimulus plan has prevented a potentially much more serious economic slowdown and helped to deliver a recovery, it will result in deterioration in the underlying fiscal position. The key question is whether the negative impact on the fiscal position will threaten fiscal soundness beyond the near term. The market implications would be immediate if investors become concerned about the fiscal sustainability in the medium and long run.

We construct a stress test to show that China's fiscal position is strong even if the contingent fiscal liabilities - created as a result of implementing the massive anti-crisis stimulus plan - are taken into account. In conducting the stress tests, we make several strong and perhaps even unrealistic assumptions to help make our points:

First, the primary fiscal deficits (i.e., excluding interest payments) in 2009-10 will be 5% of GDP per annum, despite the official budget deficit target in 2009 being set at 3% of GDP. The primary fiscal deficits in subsequent years beyond 2010 will be reduced gradually to 1% towards the end of 2014. Second, the government will pay 5% interest on its explicit debt in the next five years, despite the government having been able to raise debt at much lower cost (i.e., below 3%). Third, 50% of all new medium-term bank loans in 2009-10 are made to finance government or government-guaranteed projects and 100% of these types of loans will turn into NPLs and thus entail exercise of government guarantees. This will therefore add to fiscal contingent liabilities by Rmb3.5 trillion in 2009 and Rmb2.0 trillion in 2010, assuming that the total new loan extension is Rmb10 trillion in 2009 and Rmb8 trillion in 2010 and 70% of the new loans are medium and long term. Fourth, the government will not resort to divestment to pay down the debt despite its sizeable cash deposits and the vast amount of other assets. Fifth, GDP growth rates are 10% in 2009, 9% in 2010 and 8% in subsequent years.

We examine three different scenarios: Scenario 1 - only officially recorded explicit debt is included in the debt calculation; Scenario 2 - existing contingent liabilities are taken into account; and Scenario 3 - both existing and new contingent liabilities are taken into account. Despite large fiscal deficits in 2009-10, the government explicit debt excluding contingent liabilities will stay well below 30% of GDP throughout the next five years. If only the existing contingent liabilities are taken into account, the debt level will be substantially higher but still stay well below the 45% threshold for emerging market economies. When both the existing and new contingent liabilities - created as a result of implementing the massive anti-crisis stimulus plan - are taken into account, the overall government debt level will increase sharply and peak at around 55% of GDP in 2010 - which exceeds the 45% threshold for emerging market economies by a wide margin but is still below the 60% threshold for developed economies - and start to decline thereafter to below the 45% threshold by 2014.

The stress test suggests that the concerns about fiscal sustainability and its potential negative implications for risky assets are unwarranted. While total government debt (including contingent liabilities) under the most unfavorable scenario could reach well above the 45% threshold, the debt situation is still sustainable, as long as the expansionary fiscal and monetary policies will not be extended beyond 2010. This is because the overall debt level will decline after peaking in 2010 and drop below the 45% threshold by 2014. The fact that both central and local governments own a large amount of assets (e.g., cash reserves, SOEs, land) only makes China's already benign fiscal position by international standards - as suggested by the conventional liability-side indicators - even stronger, in our view.

Implications: First, the sound fiscal situation puts China in a much more favorable position compared with many other countries to implement counter-cyclical policies to cope with economic downturns in the short run. Second, the explicit or implicit government guarantee for the debt incurred in the context of carrying out the investment projects under the stimulus plan is credible. Third, the government should be able to finance future structural reform initiatives (e.g., establishing a basic and broad-based social security system) that helps to boost domestic consumption over the medium or long run.

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Global
The Peloton, the ‘Elastic Band Effect' and Monetary Policy
September 03, 2009

By Manoj Pradhan | London

Officials at the major central banks have been actively talking down some of the policy rate hikes priced in by markets. Given the fragility of the economic recovery and their benign outlook for inflation, the Fed, the ECB, the BoE and the BoJ will likely find it prudent to wait and watch the path that the economic recovery takes before deciding on when and how quickly they should remove monetary accommodation. On our forecasts, the BoE, ECB and Fed are expected to start hiking rates in 1Q10, 2Q10 and 3Q10, respectively. The choice for other central banks is to either ride with the peloton defined by the major central banks or join the sole breakaway from the pack, the Bank of Israel, in hiking rates earlier. The peloton travels as a unit in order to minimise air drag. Cycling in the middle of a well-developed group can reduce air drag by as much as 40%. Other central banks can similarly exploit the excess liquidity injected by major central banks by hiking in tandem with the latter or break away and hike while monetary conditions are still easing in the rest of the world. Both strategies come with their own risks.

Last week, we highlighted the surprise rate hike by the Bank of Israel and suggested that Norges Bank would be most likely to follow the BoI (see "Jackson Hole 0, Jerusalem 1", The Global Monetary Analyst, August 26, 2009), probably in 4Q09. Since then, the RBA has highlighted its concern that inflation is not likely to undershoot the inflation target for an extended period. Our colleague Gerard Minack now thinks that the RBA will hike its policy rate in 4Q09 as well (see Australia Strategy and Economics: Can Australia Recover When it Didn't Have a Downturn? September 2, 2009). An early exit from easy monetary conditions might be the necessary medicine for economies where inflation does not appear to be benign, or for those where the recovery is robust enough to withstand a less expansionary monetary stance. However, central banks may also have the luxury to allow expansionary monetary policy to remain in place for longer thanks to a benign outlook for inflation and/or a slow recovery.

What does the monetary peloton currently look like? The Morgan Stanley global economics team collectively covers 34 central banks, five of which are not expected to hike rates before 2011. Of the remaining 29 central banks, 19 will likely move in the second and third quarter of 2010. While the breakaway group of central banks hiking in 2009 will likely consist of the Bank of Israel, Norges Bank and the RBA, the peloton will likely start tightening policy some time in 1Q10, starting notably with the BoE, the SNB and the RBI. The central banks of Russia and Korea are expected to hike rates in 2Q10 along with the ECB. Finally, the Fed and the PBoC are expected to begin raising policy rates in 3Q10 along with 11 other central banks. Notably, central banks moving in 2Q10 and 3Q10 together represent nearly 74% of the global economic footprint (on a PPP basis).

Unconventional and other policy tools will be an important part of the tightening strategy: Even as active QE purchases by the major central banks are in full swing, passive QE programmes are slowly being wound down. We caution investors against viewing the shrinking of the central bank balance sheet due to an exit from passive QE programmes as a tightening of policy. If anything, moving securities that were part of the passive QE programmes off the central bank's balance sheet and into the market will strengthen the transmission of monetary policy. The unwinding of active QE programmes, however, will unambiguously mean policy tightening. We expect central banks to start unwinding active QE programmes around the same time as they start raising policy rates (see "QExit", The Global Monetary Analyst, May 20, 2009) in order to try and engineer a parallel upward shift in the yield curve.

Other policy tools will play a role in the tightening process as well. Our ECB watcher Elga Bartsch thinks that the ECB will bring the overnight rate, EONIA, from its current level some 65bp below the refi rate back up on par with the refi rate before officially hiking policy rates (see "ECB: A Not So Easy Exit", The Global Monetary Analyst, July 8, 2009). That will mean an implicit tightening equivalent to more than two standard 25bp rate hikes. In a similar vein, central banks like the PBoC could induce tightening by allowing some appreciation in the currency or by raising minimum reserve requirements. Our AXJ economics team has pointed out that central banks are also likely to restrict lending to the property sector in advance of a broad-based tightening of policy via rate hikes.

Monetary policy is still easing globally: Active QE programmes at the major central banks still have a long way to go. Importantly, these central banks still hold the option of expanding or extending these programmes, as the BoE and the Fed have demonstrated recently. In Eastern Europe, central banks are taking advantage of a global recovery to cut policy rates, having had to raise them rapidly to defend their currencies just a few months ago. Finally, the majority of central banks have finished cutting rates - most have done this faster than expected and taken rates to historical lows - and are expected to remain on hold for a considerable period of time.

There are risks to hiking early... Hiking rates while policy is still easing globally raises two concerns. The first is with regard to the efficacy of policy rate hikes. Risky assets have sustained their ‘recovery rally' while bond yields have stayed range-bound. The international linkage between markets means that the net impact of a policy rate hike on equity and bond markets in the domestic economy will likely be weaker than usual. The second concern is the impact on the currency. After its rate hike, the BoI intervened in currency markets in order to prevent a rapid strengthening of the shekel. Should Norges Bank and/or the RBA hike, their respective currencies will likely appreciate. Central banks will therefore have to find a balance between the speed at which they hike rates, the extent to which they can intervene in currency markets on an ongoing basis and by how much they are willing to let their currencies appreciate, in our view.

...and may mean hiking in stages: Early hiking is likely create at least two stages of the hiking cycle. First, the stage we described above where central banks hike against a backdrop of easy monetary policy globally. The second stage will inevitably start when the peloton starts tightening policy. Early-hiking central banks will then likely have to deal with a global withdrawal of liquidity in addition to their own efforts to make policy less accommodative in the domestic economy. The result could be a pause or a slowdown in policy tightening as they assess the impact of these global moves.

But riding with the peloton risks excessive easing and a duel with inflation later on... The vast majority of central banks are likely to start hiking rates around the same time as the major central banks. Despite having the best-performing economies, the majority of AXJ central banks are expected to hike later rather than earlier. The PBoC and four other AXJ central banks will likely hike only in 3Q10. Other regions have roughly followed suit, looking to benefit from the dual tailwinds of domestic and global excess liquidity for as long as is viable. However, inflation lags both monetary policy and the economic cycle, and such long periods of excess liquidity raise the risk of inflation further down the road.

...and trickier adjustments because of an ‘elastic band effect': Positioning within the peloton can be quite tricky and it may be preferable to stay at the front of the peloton for a variety of reasons. Being able to set the speed (to some extent) is one. But a more important reason is the ‘elastic band effect'. Riders at the back have to react faster to avoid collisions because changes in speed are amplified from the front to the back. A similar situation holds for the monetary peloton. Leaders within the monetary peloton can take advantage of global excess liquidity while still setting the pace of monetary tightening to a degree. Central banks at the back of the queue bear the risk of having to adjust their preferred policy paths at very short notice as a series of moves by other central banks lead to movements in global financial markets and excess liquidity. Central banks are not very well positioned to avoid such complications, with the bulk of them expected to move later rather than sooner.

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